The Impact of Macro-economic and

Regulatory Volatility on Investments

Gareth Sutcliffe and Miria Whittle

2 December 2016

• Current economic environment

• Regulatory volatility and the impact for insurers

• The current investment universe and relative

attraction of various asset classes

• Investment metrics and considerations

• Key front and back-office challenges

2 December 2016 2

Today’s agenda

2 December 2016

Economic and regulatory environment

4

► Extraordinary monetary policy measures have

left insurers facing low and negative interest

rate environments

Duration

Government bond yields are at an all time low

2 December 2016 5

Source: Bank of England Yield Curves, Markit: IBoxx indices, Merrill Lynch

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1.00

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6.00

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6

Spre

ad (

%)

iBoxx GBP corporate 10-15 index (spread over risk free rate)

Long term average spread

Iboxx corporate bond spreads

► Demanding central bank bond purchasing programmes and

banking regulatory strictures have threatened bond market

liquidity

Merrill Lynch Global Liquidity tracker

► Strong investor demand for yield have meant credit spreads

have remained narrow

Coupled with low spreads and low liquidity...

2 December 2016 6

Brexit

Chinese economic growth

US election

Fed interest rate hikes

Euro crisis

Uncertainty is causing extreme market volatility

%Oil & other commodity prices

There are a number of threats to political and economic stability:

Economic disruptions are causing market volatility

2 December 2016 7

Solvency II

implemented

Preparatory period

(UK PRA designated

Category 1, 2 and 3

firms) Data quality guidelines

for use in internal

models and credit

ratings

Thematic review of

ERM

Discussion paper on

infrastructure

investments

Recalculations of

Transitional Measure on

Technical Provisions

(TMTP)

Expectations of firms to

develop their remuneration

policies

Review of ultimate

forward rate

2016 Feb Mar Apr May

= PRA

= EIOPA

Re-clarification of MA

requirements Advice around Internal

Model change

applications

Consolidation of

Directors’ letters, further

Solvency II compliance

advice

4-Level Investment

Governance

Framework

Use and management

of longevity risk

transfers

The PRA and EIOPA have kept insurers busy post-

implementation of Solvency II..

2 December 2016 8

June Jul Aug Sep Oct

Identification and

calibration of

infrastructure

investments

Reduced infrastructure

debt capital charges Further advice around

Internal Model change

applications

= PRA

= EIOPA

Issued EU-wide

Stress Test

Updated methodology on risk-

free curve affecting non-EEA

currencies

Lowered risk charges

on high quality debt and

risk structures

Updated portfolios used

for calculation of

volatility adjustments to

the relevant risk-free

interest rate term

structures

Firms now allowed to recalculate

transitionals in light of low interest

rates (Brexit)

Issued proposed

updates for the

collecting of outputs

from IM for GI firms and

Lloyd’s syndicates

Update to RFR methodology,

includeing changing the

derivation of yields for corporate

bonds in case of negative yields

and update of the representative

portfolios for VA

Proposes changes to PRA

rulebook:

- Liquidity reporting

- Capital resourcing

- Market risk

Approach to monitoring model

drift and reporting of Standard

Formula SCR information

The PRA and EIOPA have kept insurers busy post-

implementation of Solvency II..

2 December 2016 9

The primary aim of this model is to establish a framework for how insurers could assess, evaluate, monitor

and report on the investment risks they take

Direct investments

Indirect investments

Level 1

Why

Level 2

HowLevel 3

Due Diligence

Level 4

Internal Evaluation &

Possible Actions

Rationale, controls, processes and

governance

Firm’s

oversight of

external

investment

providers

Internal supervisory

judgement and

possible actions for

risk mitigation

Assessment

levels

Investment type

For example: The 4-level Investment Framework

2 December 2016 10

100%

52%

12%

20%

33%

5%

8%

14%

22%

5%

13%

4%12%

1995 2005 2015

Po

rtfo

lio

Allo

cati

on

Private Equity

Property

Equity

Corp - Small Cap

Corp - Large Cap

Gov. Bonds

Port

folio

Allo

cation

Source: The Callan Associates

Expected

return7.5% 7.5% 7.5%

Standard

deviation6.0% 8.9% 17.2%

Despite volatility, insurers need to take on more

risk to achieve the same return...

2 December 2016 11

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t in

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(%

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Movements in shareholder fund investment portfolios to YE15Inadmissible assets directly held

Other assets: Other assets

Other assets: Deposits not subject to timerestriction on withdrawalOther assets: Tangible assets

Other financial investments

Credit and deposits > 1mnth

Credit and deposits < 1mnth

Other loans

Loans secured by policies of insurance issuedby the companyLoans secured by mortgages

Other var interest

Approved var interest

Other fixed interest

Approved fixed interest

Derivatives

CIS

Equity

Land & buildings

• The majority of insurance firms moved away from short-term credit and deposits

favouring ‘other fixed income’ allocations

Insurers are reducing cash holdings in favour of

alternatives...

Wider spectrum

of RE

Sophisticated

equity

strategies

Increased yield

►From sovereign to credit

►From liquid to illiquid

►From local to global

Maintain equity upside with controlled downside

►Structured products e.g. controlled VaR products

►Capital protection products

►Wider use of risk mitigation techniques through derivatives

Insurers understand Real Estate risk; now build on this

►From residential to non-residential (and vice-versa)

►From direct to indirect investments

►From local to global

Diversification

within

fixed income

Depends on internal / external AM

►Availability of assets

►Structural challenges

►Operational complexity

► Complexity of modelling

►Real advantages only come for

internal model firms

►Not widely understood

►Product variations in each market

►Avoiding securitisations

►Understanding other markets

Key

Themes Comments Challenges

Insurance market strategy: opportunities and challenges

Key European insurance investment trends – as we

see them

2 December 2016

Sources of additional yield

Illiquid asset universe

2 December 2016 14

Ground rent

Social housing loan

Infrastructure Loan

Private placement loan

Student housing loan

CMBS AAA

UK RMBS AAA

Res. Mortgage

Loan

Aviation bond

EM DebtEquity release mortgage loan

High yield bond

Swap rate YE 2015

Swap rate HY 2016

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

0 5 10 15 20 25 30 35 40

Re

turn

s p

er

an

nu

m

Indicative mod duration

Indicative modified duration

Re

turn

s p

er

an

nu

mReal estate backed loans

Infrastructure loans

Other asset backed securities

Other unsecured assets

Student housing loan

Recent market transactions

Page 15

All headlines sourced from Insurance Asset Risk

‘Royal London buys retail park for £56mn’

‘L&G lends $660mn to University of California’

‘London’s super sewer, partly owned by Allianz and Swiss

Life, seeks up to £440mn’

‘Aviva acquires freehold to £74.5mn student accommodation

property’

‘Zurich wants $2bn in green bonds’

‘French insurers invest in €425mn green energy infrastructure

fund’

2 December 2016

2 December 2016

Investment metrics and considerations

2 December 2016 17

Insurers employ a range of investment criteria:

Return/yield

Risk Amongst others;

► Balancing income vs. capital growth

► Tax implications

SCR/Capital

Liquidity

Regulatory efficiency

%

It’s important to determine the primary criteria for

optimisation

A variety of metrics are used by insurers, most

favour return on capital metrics

2 December 2016 18

67%

17%

17%

Return on regulatory capital Return on economic capital Balanced managed fund approach

What is your primary optimisation metric for setting investment strategy?

Source: EY 2016 CIO Survey, May 2016.

2 December 2016 19

► Many secondary constraints to be considered, such as investment yield,

solvency margin, IFRS earnings at risk, dollar duration gap/convexity, IRR,

value of NB, liquidity ratio, credit rating, etc.

► More focus on economic view of risk, rather than just the regulatory or

accounting view

Optimizing the SAA will ensure a balanced

evaluation of investment strategies

Improved technology will allow insurers to take

advantage of opportunities

Build a conceptual framework1Define a strategy2

Implement3

ALM strategy steps

“I don’t think interest rate risk is a rewarded risk”

Organise interest rate exposures into buckets and define constraints

Before you can transact you need to:

1. Assess impact on assets, liabilities and capital

2. Attain governance approval

3. Agree approach with investment managers

Example

Operational challenges

2 December 2016

2 December 2016 22

► In order to construct a high yielding, diversified and attractive portfolio, insurers study alternative asset classes available in the

market

► In particular: different levels of pricing trasparency, cash flows certainty, ability to source and on-going management

Type of

investment Examples

Pricing

transparency CF certainty

Ability to

source

Ongoing

management

Infrastructure Social infrastructure, economic infrastructure, energy

(including renewables)Low High Medium Complex

Real estate

backed

Residential and commercial lending, social housing,

student accommodation, equity release, ground rent Low MediumMedium –

DifficultComplex

Other asset

backed

Asset backed securities, collateralised loan

obligations, aircraft financing, shipping financingMedium –

HighMedium Easy Simple

Other

unsecured

Private placements, SME lending, high yield,

overseas (including emerging market) debtHigh High Easy Simple

Other Private equity, hedge funds, insurance linked

securities Low LowEasy –

MediumMedium

Insurers need to consider the practical challenges

before investing in illiquid assets

Managing operational constraints

Asset and liability management

The Solvency II balance sheet is significantly harder to manage.

Does one optimise the BEL, BEL + capital or other metrics (e.g. IFRS, EV, Economic Value)?

1Valuation

Private assets don’t have prices on Bloomberg / other databases.

Insurers need to be able to construct their own modelled value (in line with fair value principles).

2Capital modelling

It’s hard enough to determine a base value; how about putting distributions around these?

3Ongoing maintenance

Now you’ve got the asset on the balance sheet, what happens when you need to service the asset?

Asset data

Requirements for asset data have grown immeasurably under Solvency II. This is true for traded assets as well as private assets.

54Challenges for insurance investment and potential mitigants

2 December 2016 24

• Insurers need to adapt to the harsh macro-economic

environment and regulatory changes

• Whilst there is market uncertainty and volatility, insurers

need to take additional risk in order to meet return

targets

• Insurers need to be dynamic, and able to efficiently

assess and transact, to take advantage of opportunities

• There is value to be found in illiquid assets, but there

are a number of challenges that need to be considered

Conclusion

Thank you!

2 December 2016 25

Questions

Comments